| The valuation of special share classes in the UK
BVWire—UK offers this special analysis by Andrew Strickland upon the release of the HMRC’s Worked Example Groups “Valuation of Growth Shares” exposure draft.
As with many other jurisdictions, the issue of shares to employees in the United Kingdom (England and Wales, Scotland, and Northern Ireland) raises various valuation issues:
- How should those shares be valued for financial reporting purposes, under the provisions of International Reporting Standard No. 2—Share Based Payment?
- What is the market value or, more precisely, the “money’s worth” of such shares for tax purposes? In the UK, and doubtless elsewhere, shares issued at less than their “money’s worth” are earnings subject to income tax.
Two motivations with employment-related securities lead remorselessly to the creation of special share classes:
- The major driver for the issue of shares to employees is that of incentives that bind: Simple bonus schemes act as incentives; the issue of stock or stock options to employees provide an incentive whilst also acting as a form of golden handcuffs. That incentive is enhanced if the focus is on the growth of the value of the entity. The stock may be issued by family companies or in a private equity setting. However, the realisation of value for the employees normally requires remaining committed to the business until some form of successful exit;
- There are potential upfront employee tax liabilities on the issue or transfer of shares to the management team and others. This is at a point when their income has not been enhanced. The alchemist may appear to be working in reverse: The golden opportunity of stock ownership can appear to be base metal if the short-term impact of that ownership is a sizeable income tax liability without the cash to meet it.
The above two forces can act in tandem: Shares can be crafted that have little or no participation in the current value of the company. However, they have a defined share in the growth in value that is achieved. Such stock can provide a real honeyed incentive whilst also removing much of the sting of the immediate tax cost.
Special share classes are also being hammered and shaped as a means of managing inheritance tax liabilities. The special classes may not participate in a base value; alternatively, any participation in profits or asset values may be deferred for 20 years or more.
The Worked Example Group comprises valuation professionals who facilitate the development of examples for possible agreement with the UK tax authorities. Their focus is, therefore, not on valuation for financial reporting. They do recognize that similar valuation tools and techniques may be used for both tax and financial reporting purposes.
There are a great many different facets to the valuation of special classes of shares. This is especially so in the case of growth shares: These are shares with little or no participation in a base value as at the valuation date. They have a stated participation in the value above a defined hurdle value. The hurdle value is often rather greater than the base value.
The Worked Example Group is aware of different models in use in the UK business valuation profession.1 The market-place swirls with rumours of the agreement of various valuation structures with the UK tax authorities. Some firms suggest on their websites that they can use their special magic to obtain agreement of favourable valuations with the UK equivalent of the IRS. Meanwhile, the UK tax authorities emphasise that this is not the case: It is most definitely not a case of bad valuations driving out the good.2
In such circumstances, the Worked Example Group has decided that there is a need for some shape to the guidance available to business valuation professionals relating to such special share classes. They have, therefore, published an Exposure Draft as part of a policy of consultation with the broader business valuation community.
The starting point for the exposure draft is the guidance given in International Valuation Standards (IVS) 2022 relating to special share classes.3 IVS 2022 states that valuers may use any reasonable method to determine the value of a special class of equity. Information is then provided on three possible means of valuing such shares:
- The current value model (CVM);
- The option pricing model (OPM); and
- The probability-weighted expected return model (PWERM).
The current value model attributes values to different share classes based on the position at the valuation date. A realisation of the entire equity in an exit at that date is envisaged. Shares are, therefore, valued at their liquidation preference in a notional sale at the valuation date. If the total equity has a value of $10 million, there is no value (above amounts subscribed) for shares that only participate in surplus value above $12 million.
The main virtue of CVM is that of being conventionally intuitive. In the above circumstances, clients would recognize that value in excess of $12 million does not yet exist.
The disadvantages are apparent. We can identify several:
- The first objection is a purely technical one: The valuation of separate classes of shares requires a notional sale of the shares concerned. There is no requirement or expectation that this is in the context of the sale of the whole of the equity.
- Secondly, it is a quality of growth shares that the risks and benefits are not symmetrical: As they have a relatively low current value, the downside risk is modest. The upside potential can be very significant. It can be argued that there is some asymmetry of risk and reward in all stocks. However, that quality is greatly enhanced with growth stocks. In technical terms, there is a need to consider the option-like payoffs of growth shares.
- We move from the theoretical to the pragmatic: We cannot imagine that a majority stockholder would attribute no value to amounts in excess of $12 million in the above example. If she genuinely considered that there was no value to be had, she would be prepared to give away stock that had rights to the value band above $12 million.
- We can envisage a 100% stockholder being prepared to enter into a transaction in which rights in excess of $12 million were sold in an arm’s-length transaction. Such a stockholder would receive proceeds from the disposal of the special share class. The proceeds would reduce her investment in the company. She would be guaranteed up to the first $12 million in a sale. She would have received monetary compensation for limiting her upside.
Due to the option-like payoffs, International Valuation Standards only advocate the use of CVM in very restricted circumstances:
- A liquidity event is imminent;
- The enterprise is at an early stage of development, and no significant common equity value above the liquidation preference has been created;
- No material progress has been made on the company’s business plan; or
- No reasonable basis exists for estimating the amount and timing of any such value above the liquidation preference that might be created in future.4
PWERM is a favored tool of private equity and some other sophisticated investors: It may be used to compare different potential trade sales transactions with possible IPO proceeds and with the future value to be obtained by retention and expansion of the business. Various outcomes can be expressed in an array of values, ranging from the deeply pessimistic to the wildly optimistic. Probabilities must be attributed as weightings in order to derive a composite most likely value.
This is a labor-intensive tool requiring significant inputs and requiring impressive skills of judgement. By considering various potential outcomes, it is transparent. It recognises the potential range of different outcomes and, therefore, embraces the uncertainties implicit in any predictions of future outcomes.
There is potentially great subjectivity in the selection of probabilities. However, the use of statistical modelling tools can greatly reduce that subjectivity. For smaller businesses, it is unlikely that the skills or other resources will exist to undertake the heavy lifting required in the use of PWERM.
It is the view of International Valuation Standards that PWERM should only normally be used for the valuation of special share classes if a business is close to an exit and does not plan to raise any additional capital.
The longest section in the Exposure Draft is dedicated to various valuation tools based on option pricing models. These are the Black-Scholes option pricing model (BSOPM) and other models with the same intellectual foundations, namely the use of binomial models and Monte Carlo simulation.
It is recognised that there are special challenges in using BSOPM for the valuation of any shares in a private company. As with so much in business valuation, some leaps of faith are required.
The first concern is that of dynamic hedging: The seller of a put or call option in respect of publicly traded stock can hedge the risk. As the stock price moves, so does the hedging portfolio: The mix of the underlying stock and treasury bills is adjusted so that the effects of movements in stock prices are perfectly hedged.
The technical result of this concept of dynamic hedging is that the seller of the options has no risk; in consequence, the BSOPM includes the expectation of earning the risk-free rate of return. There is no equity risk premium within BSOPM as the risk has been stripped out by dynamic hedging.
We can all recognise that the effective sellers of the growth shares are the other common equity stockholders—they are giving up part of their equity interests. By definition, they are not able to hedge risk. This raises the question as to whether BSOPM should be modified in order to include an equity cost of capital rather than the risk-free rate in the inputs to the formula.
The second challenge is of equal moment: The BSOPM outputs are materially affected by changes to the volatility assumptions. It is a significant reach to assume that the future volatility of public-company stocks will mirror that of the past. It is a far greater stretch to try to estimate what the volatility of the stock of a private company might be if it were publicly traded. Very often, the companies being considered are small; wild thoughts of public listings would require special efforts from even those blessed with the most colorful of imaginations. In such daydreams, assumptions must be made about trading volumes and the potential for moving the market with even small blocks of shares.
The Exposure Draft has thrown out these stumbling blocks for the views of the business valuation community. It has done so together with some thoughts:
- Is it possible to argue that there is a significant difference of impact between the passive purchaser of options in the market and the manager playing an active role to achieve bigger and better results for his employer? If so, can this thought be used to neutralise the concern about the absence of dynamic hedging in the arena of private companies? If a growth share is akin to an option, the option holder is committed to positive actions that are designed to improve the likely outcome.
- Anything other than very tiny holdings of the stock of smaller public companies are often traded in the markets over some days with some considerable caution. There is a concern that a purchase or sale of anything other than insignificant quantities of stock can move the market. Is this a factor that should be recognised when considering the notional volatility of the stock of a private company? If so, can the volatility of guideline public companies be dampened by the use of a two-day or three-day moving average of closing prices? Is this a better reflection of what would be likely to happen in the surreal world of a smaller company having a free float?
The Worked Example Group hope that the wider business valuation community will engage in responding to some or all of the many questions that have been thrown out by the Exposure Draft for consideration. We are seeking a better consensus and an improved quality of valuations of growth shares.
1 There are no generally recognized business valuation credentials for the UK market. The main qualifications of business valuers are accountancy, followed by ASA and RICS.
2 One area of concern is that there is no obligation on any taxpayer to seek professional help when negotiating values with the UK tax authorities.
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